Decentralized finance, or DeFi for short, is a concept in the crypto world that is gaining traction and showing promise, despite valid scepticism. Decentralized finance is founded on two key tenets:
1. Blockchain technology, which offers decentralisation
2. Non-custodial products imply that there is simply a protocol between the user and the financial product being used.
What is decentralised finance, given these guiding principles? What are its advantages and disadvantages, and how is it perceived by the all-seeing regulators?
What Is Decentralized Finance, Exactly?
A straightforward yet effective place to start when attempting to describe the developing phenomena is by dissecting the word "decentralised finance."
Let's begin with finance.
The word finance is defined as "matters relating to the management, creation, and study of money and investments". The parts of this definition that are most applicable to the DeFi discussion may be the development and management of investments and money.
Investing, borrowing, lending, budgeting, saving, and predicting are only a few of the specific examples of finance given by the Corporate Finance Institute (CFI). The most applicable of these instances when it comes to decentralised finance may generally be lending, investing, forecasting, and borrowing.
What about the "decentralised" component of DeFi, though?
Financial platforms and services that are driven by blockchain technology are referred to as decentralised finance. In general, these services may allow users to borrow or lend cryptocurrencies, buy and sell coins, speculate on the future value of commodities, and buy or sell tokenized assets, while their goals and specifications may differ.
Decentralized finance is a new way to partake in the economic activities that assist the making (or losing, if you're unfortunate) of money, similar to other evolutions in the financial industry over time. The main draw is that users control the mechanisms that support their transactions, eliminating the need for a middleman or institution (at least in theory).
What enables DeFi to function?
In brief, decentralised money is made possible by blockchain technology and particular protocols. The internet sits below both of these essential components; without it, blockchain technology would not be viable.
A protocol is described as "a set of rules or processes that regulate the movement of data between two or more electronic devices," according to one definition. When there are protocols on a blockchain, a network of computers called nodes executes those protocols. These protocols control characteristics of a blockchain like:
The procedure for blockchain transaction approval
The procedure for adding new nodes to the blockchain
These protocols support blockchains generally, making decentralised financial products possible. What each DeFi application may achieve for its users depends on the precise purposes for which these protocols are used.
What Advantages Do Decentralized Finance Systems Offer?
The advantages of decentralised finance differ depending on the broad DeFi category and even the application.
However, in general, decentralisation as a concept is what contributes most to the advantages of decentralised finance. Without decentralisation, DeFi's advantages are much less clear.
According to this line of reasoning, centralised financial institutions have a number of flaws, including but not limited to:
Lack of control over the operation of the system by those who support it (the financial consumer)
Lack of transparency in the decision-making process that affects the financial system
Lack of transparency and control over how your personal deposits are handled the potential for your deposits to be at danger due to arbitrary or dishonest judgements made by financial institutions or regulatory authorities
DeFi proponents seek to reverse these shortcomings. Their objective is to market their DeFi goods by positioning them as the antithesis of centralised financial institutions—decentralized financial products.
Benefits of a perfect decentralised financial system would be:
Participants' (financial customers') democratic power over a system's operation
There isn't a centralised body with excessive ability to decide what happens to participant deposits.
Greater client reach regardless of location, as all participants should theoretically need is a mobile device with internet access.
Less exposure to external attacks thanks to decentralised security measures
Greater freedom to democratically adapt some blockchain protocols, which could, among other things, allow for the dynamic adjustment of interest rates for cryptocurrency loans.
DeFi's strong emphasis on reliability stems from the fact that contracts are enforced by smart contracts, which control currency exchange. Smart contracts offer guarantees that your coins will be delivered when specified criteria are met, as opposed to relying solely on the good faith of a bank to produce your assets (which they have lent out in the interim) when you ask for them.
Remember that these are the principles of decentralised finance, and only time will tell how closely actual DeFi solutions resemble them.
How is DeFi Doing Right Now?
Decentralized finance is currently almost exclusively associated with the Ethereum (ETH) blockchain, which is renowned for its adaptability and user-friendly design. DeFi Pulse highlights the advantages that current Ethereum-based DeFi devices provide:
Cryptocurrency borrowing and lending
Decentralized marketplaces to buy cryptocurrencies
The capacity to place bets on changes in asset values by acquiring synthetic derivatives
Services for peer-to-peer payments
Asset management using tokens
A comprehensive list of DeFi products, including market leaders in lending like Aave, Maker, and Compound, can be found here.
Fair to say that non-decentralized financial products are mirrored by decentralised financial products, but without the middleman (traditional financial institutions). DeFi differs from more established financial products in another way since the decentralised finance industry is still relatively new and is developing quickly.
What Do Regulators Think of DeFi?
Regulators seem to be a rising threat that may eventually target DeFi goods. In an effort to combat digital fraud, the Security and Exchange Commission (SEC) finally took action against ICOs, and some have even claimed that "regulators are circling" the DeFi industry.
As with any regulatory concern, until regulators—the SEC or someone else—take an overt action, speculators and opacity will reign. If history is any guide, calls for self-regulation as a defence against external regulation may range from ignorant to unduly hopeful.
Those hoping to resist outside regulation are undoubtedly not helped by the idea that those who develop DeFi products are not spawning true decentralised products but are instead doing so for their own personal advantage.
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